Many business entities raise money by means of a mix of debt instruments, such as bonds, and equity instruments, such as stock. The mix selected by a particular entity is influenced by prevailing interest rates, as well as other factors such as the extent to which the market is willing to purchase newly issued instruments of one type or the other at any particular time. Convertible instruments have some of the qualities of bonds as well as some of the qualities of stock. A convertible instrument, such as a convertible bond, is a debt instrument that can be converted by its holder into a number of shares of stock of the issuer, the number typically being fixed or being determined by a formula. Often, such an instrument has a conversion price per share. The conversion price is divided into the par value of the bond to determine the number of shares available in the conversion. Thus, a holder has the option of converting the bond into shares of stock, as opposed to simply cashing in the bond in order to retire the debt obligation of the issuer. Convertible bonds afford a holder the opportunity to benefit from increases in the issuer's stock value while generally providing the protection of a guaranteed return if the stock value does not increase.
An exchangeable instrument, such as an exchangeable bond, is similar to a convertible instrument except that instead of being exchangeable by the holder into equity, such as shares, of the issuer, the exchangeable bond may be exchanged for shares of a third-party company. Exchangeable bonds are generally treated in an identical manner as convertible bonds under an issuer's consolidated generally accepted accounting principles (GAAP) where such bond is convertible into the equity of a consolidated entity. The same terminology may be used to describe convertible and exchangeable bonds, and accordingly when “convertible” and other terms applicable to convertible bonds are used herein, it should be understood that such terms are referring to exchangeable bonds.
Traditional nonconvertible bonds are issued by an Issuer, who is in effect a borrower. Investors or holders of the bonds may be considered lenders. For the use of the Investor's money, the Issuer pays a coupon, or interest rate on the loan, to the Investor. A bond indenture, the formal written agreement between the Issuer and the Investor that governs the bond issue, sets forth the obligations of the Issuer. Such obligations may include the coupon, interest payment dates, the maturity date, and repayment conditions.
In a traditional convertible bond, an Issuer embeds a conversion option on its stock into a bond. It is the conversion option that offers Investors in the convertible bond the opportunity to convert the bond into a fixed number of shares of the Issuer's common stock. The number of shares is set at a premium to the market price, essentially creating a written call option, or a contractual right to buy a specific number of shares at a predetermined price before expiration of the contract, on the Issuer's stock in the convertible bond. Because the Investor is getting the opportunity to participate in equity gains via the bond, the coupon for the bond is lower than for a normal debt instrument with a similar maturity. Effectively the Issuer embeds the conversion option into the convertible bond in exchange for paying the Investor a lower coupon. In addition to the obligations documented in an indenture for a traditional nonconvertible bond, the indenture for a convertible bond may also include conversion provisions such as a conversion price, and an anti-dilution clause.
From an Issuer's vantage point, two key factors to consider when issuing bonds are the tax treatment and the accounting treatment. For traditional nonconvertible bonds the Internal Revenue Service allows a tax interest expense equal to the extent of the coupon, which is the Issuer's straight borrowing rate and may be, for example, 6-7%. For accounting purposes, the Issuer also must record interest expense equal to that coupon. Traditional nonconvertible bonds do not provide opportunity for an Investor to benefit from increases in the share price and have a relatively high interest expense for accounting purposes. For traditional convertible bonds, the Internal Revenue Service typically also gives an Issuer of a convertible bond a tax deduction to the extent of the coupon, but here the coupon is reduced as compared to the traditional nonconvertible bond. If a bond is issued with a 2% coupon, then 2% is the deductible amount. For accounting purposes, the Issuer must record a tax and accounting interest expense equal to the coupon. Therefore, traditional convertible bonds have a relatively low allowable tax deduction. Traditional nonconvertible bonds and traditional convertible bonds each lack the cumulative benefits of a relatively high tax interest expense deduction, a relatively low accounting and cash interest expense, and the opportunity to participate in equity gains.